Drought Could Dry Up Expansion
Economic events are sometimes moved by forces beyond the control of policy-makers and even beyond the luck of the Irish.
Because of the weather, 1988 threatens to go down as a year of major crop disasters. As of this writing, growing conditions continue to be bad, and, for farmers in some areas, the point of irreparable damage has already passed. True, even in this hot, dry summer, crops in some parts of the country are doing fine. And in many others, a change in the weather can still turn a disaster into a fair year. But the increasingly likely outcome is for a crop year in the range of poor to terrible. Assuming that outcome, what would be the economic consequences?
One immediate issue is farm incomes. Farmers in the parts of the country that are not devastated by the weather will do extremely well. They will benefit from the higher prices that will come from the general drought, while their own crops will be reduced only moderately. But other grain producers will see their incomes decline, sometimes to ruinous levels, as crop yields fall by a larger percentage than the rise in prices.
The big issue for most Americans is how consumer prices will be affected. It is far too early for precise estimates, but we can get a feel for what might happen.
If prices of the major Farm Belt commodities should double and merely be passed through--dollar for dollar--in the final cost of bread, margarine and other products that derive from these commodities, that would add about 1% to the consumer price index. But all the price effects will not occur so simply. Many of the affected crops are used as animal feeds, so their effects on consumer prices are long delayed.
Indeed, higher feed prices will initially reduce the prices of meat and poultry because animals are brought to slaughter earlier than they otherwise would be, thus expanding the immediate supply.
But, eventually, with fewer animals available, their prices rise, reflecting the longer-run effects of higher feed prices. In the case of poultry, which normally comes to market only a few months after being hatched, this cycle takes place quickly, so prices will be rising well before the end of the year. With cattle and hogs, the cycle takes longer, and prices could be lower rather than higher for most of this year as a result of higher feed grain prices.
The cycle in meat prices will move much of the impact of a bad harvest on the CPI from this year to next. At the same time, price increases could spread into other consumer foods through several channels. For instance, as meat prices rise next year, consumers will switch a little of their demand from meat to fish, and this will drive up the price of fish. As more acres are planted next year in response to this year’s reduced supplies, the demand for fertilizers and herbicides will rise, increasing their price. This will raise the cost of producing other crops that also use these chemicals.
Finally, some land may even be diverted from other crops to the grains, corn and soybeans that have now risen in price, thus reducing supplies of other farm products. For all these reasons, the prices of foods not directly affected by this years drought, may, by 1989, also rise in price.
All of these are very real possibilities, but none are predestined. Not only can the weather still improve this year, but previous experience with bad crop years shows a very wide range of outcomes for consumer prices. In 1973-74, poor worldwide crops doubled many farm prices. And between late 1972 and late 1974, the food component of the CPI rose 35%. But this huge increase in consumer food prices occurred because wage and price controls were being lifted at the same time and because the environment was inflationary.
At the other extreme, the very bad 1983 drought in the U.S. Farm Belt sharply reduced the size of crops but had little effect on consumer prices. Between late 1982 and mid-1984, wholesale prices of crude food and feed stuffs rose 12% and this translated into a 6.5% increase in CPI food prices between the end of 1982 and the end of 1984. Thus, food prices just kept pace with the low level of general inflation at that time.
If this year’s experience resembles that of 1983, the broad economic impact of the drought will be quite limited. However, the potential for larger price effects is greater this time because livestock herds were already at very low levels at the start of the year. If a lot of animals are now slaughtered because of the rise in grain prices, meat prices could be sharply higher in 1989. In 1983-84, meat prices were hardly affected.
The most likely outcome, then, is for somewhat worse price news this time than in 1983. A 10% rise in consumer food prices next year would add about one percentage point to the rise in the overall CPI. Added to an underlying rate of CPI inflation of around 4%, this would give us a 5% increase in the CPI next year. Because the economic expansion has been reducing unemployment and tightening labor markets, a 5% rate of increase in consumer prices for an extended period of time could contribute to some acceleration in wage increases, which have been very modest in the expansion to date, thus ratcheting up the inflation rate a bit further.
All this is painting a bad-case outcome. But for the first time since this economic expansion got started after the steep recession of 1980-82, the risk of a measurable pickup in the inflation rate is great enough to warrant attention. If such a pickup occurs, it will once again force the Federal Reserve into the hard choice of tightening monetary policy and risking a recession, or accommodating the price increases and risking a permanently higher rate of inflation.
That is a choice that the Fed has not had to face for some time and that it would not like to confront in the future. But it may have to.
